Measuring Well-Being

The Fable of Smith and Jones

You moved into a new, upscale neighborhood a few years ago. The two biggest homes in the area were owned by Mr. Smith and Mr. Jones. While the homes were comparable, similarities between the two gentlemen ended there:

• Mr. Smith had two older model automobiles, maintained his own lawn and property, rarely went on vacation and played golf at the local public course. He didn’t entertain very often and rarely dined out.
• Mr. Jones, on the other hand, had three new expensive automobiles, had a gardening service come weekly, went regularly on exotic vacations, and belonged to the most exclusive country club in town. He hosted frequent, large parties at his home and often ate at the best restaurants.

Initially that was all you knew about the two gentlemen. Based upon this evidence, you assumed that Mr. Jones was doing well while Mr. Smith appeared to be less well-off.

About a month ago, Mr. Jones’ home was foreclosed and two of his autos were repossessed. Then Mr. Smith provided aid to Mr. Jones by paying off the loan against his remaining car, a large BMW, to prevent him from losing that.

You learned that Mr. Smith and Mr. Jones earned equal amounts of income each year. How could someone who looked so prosperous lose most of his assets? How could the man you assumed to be less well-off be in a financial position to assist the “richer” man?

The answer is simple — Mr. Jones spent everything he made and borrowed to spend even more. He appeared more prosperous because you were seeing only his spending. Eventually his unsustainable lifestyle and borrowing caught up with him, and he was unable to honor his obligations.

Had you been privy to the personal balance sheets of these individuals, your judgment regarding who was doing well would likely have been different. Mr. Smith was accumulating net worth while Mr. Jones was living high via debt. High Spending may impress neighbors, but if it is not backed by wealth creation it cannot continue and often ends in bankruptcy.

The Bigger Meaning To The Story

This allegory used the fictitious Smith and Jones to illustrate an important point regarding economics and how well-being is measured. Gross Domestic Product (GDP) measures spending, the measure you used to judge Smith and Jones. If Jones were an economy, his GDP would have been considerably higher than Smith’s. Jones would be considered successful, at least until he filed bankruptcy.

Now Mr. Jones will spend less as a result of his financial condition. He will be forced to save to pay back Mr. Smith and other friends who helped him out. Judging him in terms of spending for the future he will not appear to be doing well. In reality, with his same job and income, he is doing just as well as before. He is just not spending as much.

There are two lessons that can be learned from this simple story:

1. Spending is not a useful measure to determine economic health.
2. The US will have to adjust just as Mr. Jones did.

1. Spending — Would any rational family determine success by how much they spend a year? Of course not. Family and business success is measured in terms of net worth (wealth). If your wealth increases, your economic condition improves. If not, then the economic condition has deteriorated. (An obvious exception would be retirees who accumulated net worth for the purpose of consumption during their “golden years.” You can’t take it with you.)

There is no difference between individuals, families and businesses in terms of how success should be measured. If net worth measures the well-being of the economic units (except government) which make up the economy, then why is net worth not the proper measure for judging the well-being of an economy? Why don’t we measure economic success according to some change in aggregate net worth from one year to the next?

Gross Domestic Product measures spending. This statistic provides a measure of economic activity during the year, but that is not necessarily a measure of economic well-being. We saw how Mr. Jones “jacked up” his spending (GDP) via excessive use of debt. That worked for several years but the foolishness of his spending finally caught up with him.

2. Adjustment — The US economy has been Mr. Jones. We have lived the high life for at least the last thirty or so years. GDP has been driven by debt, not by incomes. Savings have been at historically low levels. The country is in the same position that Mr. Jones found himself in. We haven’t been foreclosed upon (yet!), but that is only a matter of time given our current path. To avoid this ending, we must alter our spending to conform with our income. That is true on the individual level as well as the government level.

Just as GDP was inflated by borrowing from the future to consume more than we made, now GDP will be deflated as we are forced to spend less and save more. Debt must be liquidated. Short of defaults (and inflation is a form of default), it can only happen by paying it down out of current income. That means less spending and less reported GDP.

But in terms of the proper measure of well-being, net worth, it means that the country’s wealth will be increasing. That in itself is a good thing. What is a bad thing is that the slowdown in spending (necessary) will not support the numbers of department stores, health clubs, cell phones, etc. etc. that were built based on recent unsustainable spending levels.

To correct the economic mess, malinvestment needs to be liquidated (inevitable) and redeployed where it is needed. This adjustment will be painful, but not as painful as continuing down our current course.

Sadly, there is no magic to economics. Keynesian economics promises magic, but that is exactly the reason we have reached this point. There is no solution other than repairing personal and government balance sheets. More debt is the absolute wrong way to go. So is more money printing, a surreptitious version of default.

Tags: Allegory, economy, GDP, Jones, Net Worth, Smith, Spending, wealth